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Equities.com invites you to watch Legalized: Making Sense of the Marijuana Green Rush our ground-breaking roundtable discussion on the impact of recreational marijuana's legalization in the United States. Our amazing panel of leading experts offer incredible insights from their perspectives of the regulatory, legislative, medical and business aspects of the industry. Click here to watch now.

The legalization of marijuana, both from a recreational standpoint and for medicinal purposes, has generated a lot of excitement. With the recent developments toward wider acceptance, interest in the trend has surged significantly. Debates on the cultural and societal impact has picked up, with advocates and supporters arguing that the benefits of legalized cannabis outweigh the potential drawbacks.

From an economic standpoint, the argument has been overwhelmingly positive on the bullish potential for the industry. This is evidenced by the incredible price spikes in popular marijuana stocks. While the exuberance helps to bring more attention to legitimizing the industry, investors would do well to approach these opportunities with the utmost caution.

Equities.com had the opportunity to speak with Alan Brochstein, founder of 420Investor.com and one of the few analysts covering the growing universe of marijuana stocks with a professional eye. Alan discusses some of the opportunities and potential pitfalls as the industry evolves, and what investors need to do to capitalize and protect themselves.

EQ: Marijuana stocks have been an area of growing interest for investors for a number of years now. With the legalization of marijuana for recreational use taking effect in Colorado and Washington recently, that interest is as high as it’s ever been. What is the potential here that’s drawing so many investors into this market?

Brochstein: These are exciting times. I think we saw earlier last year that interest really picked up. After the election in late 2012, people were getting excited, but they weren’t fully on board until it was a done deal. The news media really jumped on it January 1 when Colorado kicked in. All of a sudden, a large part of our population that really wasn’t tuned in became excited as well, joining the early adopters of this theme.

So I think the groundwork is there. The first state went legal, and the second state is on its way. I think people are starting to really catch the industry’s bullish outlook.

EQ: The industry shows a lot of promise but is still a bit like the Wild West given its early stage. You started 420 Investor to analyze the “Green Rush” and the opportunities in the cannabis space. So far, the portfolio has performed quite well. What motivated you to start covering this market?

Brochstein: The Wild West is exactly what it’s been like. I first stumbled onto this space about a year ago after reading an article on it. I didn’t even realize that these types of stocks existed. My career has been more in the institutional world, certainly focusing on mid-cap and large-cap equities for the most part, and no penny stock exposure. So I was totally clueless to the whole marijuana stock phenomenon a year ago.

I invested a lot of time into researching it and realized that there was not many people looking at it beyond the retail-investor level. By the summertime, two things happened in August that brought more attention to the space.

First, Dr. Sanjay Gupta, the chief medical correspondent for CNN, did a huge reversal regarding his perspective on medical marijuana. He had previously written it off as hogwash, basically.

Secondly, Eric Holder and the Department of Justice came out with the Cole Memo that took a hands-off approach, sharing eight separate rules that both Washington and Colorado had to follow to legalize marijuana. It didn’t make things crystal clear, but it gave some clearer guidelines. One of the rules said to keep it away from the kids, and another was to keep it away from going interstate, and there were six more rules like that.

So that sparked me to follow this industry more closely. You have all these companies that are a tiny part of a highly fragmented industry that was going from illegal to legal. I’ve certainly learned a lot more since then, obviously. I launched 420 Investor in September.

EQ: Can you talk about your strategic approach and what you offer your subscribers?

Brochstein: You mentioned my performance, which I’m happy about, but that’s not what I’m about. What’s happened is, 420 Investor has become a huge community where like-minded individuals share their own research and communicate with one another. So even though I offer portfolio recommendations, that’s really only a small part of what we do.

The value is two-fold. I’m kind of the community leader, but I’m certainly not telling people what to do. We have a lot of different interests, and some people like to focus on the short term and some are more focused on the long-term perspective.

We want to facilitate conversations between investors, sharing our diligence, market information, and so on. There’s not too many people focused on the sector yet with a professional approach, and that’s what we’re trying to do with 420 Investor.

EQ: Right now, two states have legalized marijuana for recreational use, and 20 states have legalized it for medicinal purposes. It seems many bulls of the Green Rush believe widespread legalization is a foregone conclusion. Do you agree with that assessment?

Brochstein: It’s kind of like Goldilocks—not too hot or not too cold. You want it to be just right. What that means to me is if we were to go legal all of a sudden in the United States tomorrow that would be pretty bad for these stocks. I don’t think anybody thinks the federal government is going to go legal because there’s a lot of political reasons why it’s going to be slow.

On the other hand, if we were to backpedal a lot, and the federal government was going to halt the progress that would be detrimental as well.

The reality is, the current scenario of state-by-state adoption is realistic. The research out there has gotten a little more optimistic about the timing and it’s pretty easy to see that Colorado has gone very well. The numbers so far have shown that the tax revenues are higher than expected. Given the situation with state governments across the country still facing some funding pressures, combined with something like 58 percent of people in a recent poll believing it should be legalized, everything points to a progression toward legalization. I think the percentage of people who believe it should be legalized for medicinal purposes is in the 80s as well.

I don’t expect it to happen overnight because we are seeing some problems in some states. Arizona has been a disaster, and more recently, Massachusetts intended to award about 35 licenses but only awarded 20. There was some controversy with that, but it’s two steps forward and one step back. But the trend is moving forward.

EQ: Recently, the banking industry was given approval to work with marijuana companies. How significant was this for the industry?

Brochstein: This is another one of these areas that need to be addressed. It’s a start. My initial reaction wasn’t that positive because it really only addresses a small part. I was in Colorado in January, and I didn’t see anybody wheeling around wheelbarrows of cash.

That’s really the issue, because a lot of the dispensaries have to deal in cash only, and that’s dangerous. The government doesn’t want that to happen, both in safety and tax-compliance issues. It’s much easier to track credit cards. So the legislation—actually it was more of a directive from the Department of Justice and a unit from the Treasury—gave a little more clarity but didn’t go far enough to really clear things out.

So it’s another example of one of these gray areas where they’re moving in the right direction, but it certainly wasn’t a law. So it’s a step in the right direction and ties into the slow-but-methodical pace, similar to what happened in August when the Cole Memo came out. It’s basically baby steps, I would say.

As far as the industry goes, I think it was very positive for anybody on the build-out side. There’s a few companies that are better-positioned than others in the right spot. To the extent that people have more confidence that this trend is real, then you’re going to see more medical dispensaries, retail stores, and cultivation centers.

But as far as the institutional banking side, this did not really open the door for investment banks or commercial banks to plow their own money into the sector from a funding standpoint.

EQ: As of right now, the overwhelming majority of marijuana companies that are publicly traded are in the over the counter and pink sheets market. The penny stocks arena certainly has a reputation for higher risk. How do you discern the quality companies from the me-too or hype stocks that lack staying power?

Brochstein: The fact that over 90 percent of the stocks that I’m tracking are in the OTC or on the pink sheets kind of complicates things. In some ways it’s good for me because I don’t have a lot of competition from other investment professionals looking at them.

Unfortunately, a legitimate company will have a very difficult time doing an IPO right now, and quite frankly that’s because of the banking laws. I think that’s going to change this year because it’s not so much that the laws are prohibiting banks like Goldman Sachs or Morgan Stanley from underwriting a deal, it’s just the concerns about the potential of getting in trouble that keeps them away.

It’s just this gray area, but everybody is getting a little more confident. So we will see that open up more. But in the meantime, we have to deal with a lot less disclosure than institutional investors would want to see.

What I’ve tried to do is focus on the companies that have that transparency. I go out of my way to speak with management, certainly more than I would when I would cover mid and large-cap companies. You really have to take that extra step and spend a little more time with the people to get what their plan is and find out what their access to capital is. That’s really the big differentiator, and those are the kinds of steps I’m taking when looking at these companies.

EQ: Are there any companies right now that exhibit the types of characteristics you look for when analyzing good long-term opportunities?

Brochstein: Yes, and I don’t mind naming a few companies for the purpose of using them as examples. I’m not saying go out and buy these names, but they’re good examples of companies that meet some of my criteria.

Growlife, Inc. ($PHOT) – They announced a program in the fall called GIFT program, which stands for the GrowLife Infrastructure Funding and Technology. It sounded great because it gets to the problem that the market has with not having enough capital to expand. So they’re trying to help solve that. They also announced that an unknown entity called CANX will be providing the funding for the program. I’ve come to learn that these are wealthy individuals that can’t necessarily put their names and faces directly on a public company because of the stigma of marijuana. So long-story-short, this is a good example of one of these public companies has really changed the game by accessing private capital. There’s also been some deals announced and some additions to their Board.

Advanced Cannabis Solutions ($CANN): They’re a Colorado-based company that was able to fund their business model with a loan agreement with Full Circle Capital Corp. (FULL) , a business development company (BDC) out of New York with a really good senior management team. So there you have a business model that has been validated by a publicly traded company.

mCig, Inc. ($MCIG): This is a Bellevue, Washington company, and Paul Rosenberg, their CEO, has really gone out of his way to be transparent. He has funded an acquisition as well as the compensation for an employee hire out of his own pocket rather than shareholder’s. Basically he’s reduced his own equity exposure to build shareholder value. They’re doing a spin-off that will take place in April, which essentially would mean he is donating his shares back to the company.

That’s three examples of companies I’m looking at. The big point is, that it’s probably the 80-20 rule. You take the universe, which is growing every day, and you break it down.

Really, only about a quarter of the names are worth investigating, and even then, you’d have to look at the valuations. Then the middle 50 percent probably aren’t really worth your time. And the remaining bottom 25 percent—I mean, watch your wallet!

EQ: You said that a lot of the investors or traders excited about the marijuana space right now are focused on the goal of getting rich quick. Is there a real opportunity to do that with the way the trend is currently playing out? What are the risks involved when speculating this market or any market in that way?

Brochstein: I think the risk is more associated to risks in the penny stock arena. Anytime you’re dealing in an area that lacks transparency and kind of heavy on unsophisticated investors, you run into some risks that are inherent to that market. That’s really the issue I think.

In this case, in particular, you already have FINRA all over it. They’ve been on it since last August, and reiterated it in January. They’re not happy with the types of press releases that are coming out. I mean, I’ve seen some really bad examples, by the way.

Ironically, you have three of the best known marijuana stocks are still pink sheets. It’s ridiculous. They’re old and have been around for a while, but they have not been able to climb out of the pinks. So I would say that investors need to be careful with these new companies, and certainly ask why these other companies haven’t been able to move out of the pink sheets.

I’m not saying they’re necessarily bad, but investors need to understand what the circumstances are because being stuck in a scam company is a real risk.

We spend our time trying to point those out. You should always know what you’re trading or investing in. It doesn’t mean you can’t make a lot of money, but when the tide goes out we’ll see who’s been skinny dipping.

EQ: For investors who haven’t been keeping up with this space, but are drawn in by the high performances of late, what words of advice would you offer them?

Brochstein: What I’ve tried to share with my subscribers is that this is a great industry, but these companies right now that you can buy may not necessarily be the ones we’re going to be talking about in a year or two. There are some really good private companies trying to figure out how to become publicly traded.

So you’re going to have the shiny new toy syndrome really hurt you then, because when you have really good companies and they’re demanding really high market caps, it’s going to shakeout a lot of these other companies that don’t have a lot of substance to them.

Another thing that I point out is that the valuations are very high. We’re fighting that, but it’s very difficult to justify the market caps of even the companies I do like. It doesn’t mean they’ll go down, but it’s certainly something to be cognizant of.

So I would suggest that people spend a lot of time learning right now and be very careful with what they do with their investments. There’s a lot of “geniuses” out there, apparently, because they were at the right place at the right time. But it’s not always going to be as easy as it has been the last few weeks.

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